April 30, 2014 | By fischer |
You may have found that the stock market seems like a catch 22. On one hand, it’s the fastest path to wealth, yet on the other hand, it has so many confusing cycles. Many times investors are scared out of their positions when they see the market move against them, only to see months later that they could have made a big profit. One of the keys to making significant returns in the market is value investing, which involves hunting for stocks that are selling at discount prices.
Investing in Undervalued Stocks
Since not all stocks were created equal, it follows that not all stocks trade the same way. Some stocks rise despite weak fundamentals, while financially strong companies can experience dips in stock prices. Undervalued stocks reflect companies that should be trading higher but somehow got knocked down by market nuances. It’s very easy for stocks to run up and down based on daily news stories, as Wall Street analysts are constantly sending out mixed messages about the economy and specific companies.
Value stocks tend to be ignored by these analysts, who constantly feed the media projections about prominent companies and issues affecting the economy. You have to be very careful about who you trust when it comes to investing because many market forecasts prove to be inaccurate. By studying the financial statements of individual companies and tuning out market noise you can get a better grasp of which companies are doing better than stock prices indicate. Sometimes quality stocks can fall due to a series of negative news reports and then recover after the bad news has subsided. That’s why creating a portfolio of value stocks can be very beneficial. Warren Buffett is living proof.
Studying Relevant Metrics
By studying statistics such as annual and quarterly earnings, price earnings ratio, book value and whether earnings per share is positive or negative, you can gauge the financial health of a stock. Other important indicators to look at include the stock’s 52 week price range, average volume and its volatility. Stocks trading at a 52 week low, yet seem to have sound fundamentals, help solve the mystery of value investing. Income statements reveal which direction revenue is moving while balance sheets reveal the company’s progress in growing assets while reducing liabilities.
Comparing companies within the same industry gives a more clear perspective than just studying individual stocks. Many times stocks within the same industry trade in similar patterns or with the broader market. But when you find a lesser known company that is outperforming competitors on a fundamental level, yet has suffered a stock price decline, then chances are you have found an undervalued stock. The best approach for value investing is to look for industry laggards and study their fundamentals.
Avoid the Herd Mentality
The market is like a herd because much of the trading is based on traders following bigger traders. But the herd mentality does not always produce profits and can lead to volatile price action. Usually too much good news causes too many investors to flock to a stock, which inflates its price, while too much bad news leads to price deflation. In either case, you need to beat the crowd. Value stocks work because they can move up quickly after declines when big institutions realize their potential.
While many traders of the herd are chasing the market looking for quick gains, your goal as a patient value stock investor should be to realize returns over the long term. Sometimes it can take years for value investing to materialize, but the returns can far exceed short term trading strategies.